Repo

This topic describes the Securities Repo for short term capital needs and works similar to a collateralized loan.

Repurchase Agreements or Repo is a short term borrowing for dealers in government securities. Repo is typically used for short term capital needs and works similar to a collateralized loan. Usually, a dealer sells securities to an investor and buys back at a slightly higher rate. This difference is the price is the interest rate or repo rate. For the party lending/pledging the security, it is a repo, and it is a reverse repo for the other party

Let us understand the reason why one needs to enter into a repo agreement with the following example:

• Bank A wants to raise cash today to invest this amount into a business and may return the cash tomorrow. It can enter an agreement with a bank B where bank B can lend the required cash to bank A for a day. Bank A expects to borrow cash from Bank B. Therefore, Bank A is the cash borrower.
• Bank B lends cash to the Bank A. Therefore, Bank B is the cash lender.
• Bank B now expects the cash to be returned within a day. Bank B in this instance is known as the cash lender and bank A is the cash borrower.
• Bank B is now exposed to the risk that Bank A might not return the borrowed cash before or at the end of the transaction.
• Bank B, the cash lender, expects some form of collateral such as securities in return. This collateral is required to protect against the risk that Bank A might not return the cash within the required time. This is secured financing by using collateral to mitigate the risks that the counterparty might default.
• As a result, the security has now reduced the risk of bank B as it can sell the security in the worst-case scenario. Bank B can also sell the security at a higher price to earn a profit.
• Subsequently, Bank A will now be charged a lower interest rate. This rate is known as the repo rate and it is dependent on a number of factors such as the liquidity of the security.
• Bank B can also cut the value of the security by applying a haircut (usually a percentage) to mitigate against the counterparty risk or the risk that the value of the security might decline.

To Summarize:

• Repos are short-term lending agreements. Their maturity can be a day long.
• Repos are secured by collateral such as securities.
• A haircut is applied to mitigate against the counterparty risk and to mitigate against a decline in the value of the collateral.
• One party sells securities and borrows cash and commits to buying the security back at a future date. The buying back part of the agreement gave them the name of repurchase agreement.
• The borrower is said to have entered into a repo agreement. The borrower can also repurchase the securities on demand.

“A repo is a loan secured against collateral”